Worse Than Wall Street

Article excerpt

Byline: Stefan Theil

How shaky European banks could tip the world back into recession.

Europe's leaders have a simple explanation for the current financial crisis on their continent: greedy Wall Street hedge funds caused it. Rapacious investors made wild bets on Greek debt, the argument goes, which drove up borrowing costs and made the crisis seem even worse than it was. That bad behavior pummeled the euro. To hear EU leaders tell it, they have since fought off the barbarians with a $1 trillion bailout, saved the euro, and even ensured "peace on the continent," as French President Nicolas Sarkozy boasted.

But Europe's problems are far from over. Just hours after the bailout, the euro continued its slide, falling from $1.28 per euro to $1.19, before clawing its way back to $1.26. More worrying, European banks have cut back on their lending to each other--just as they did during the 2008 financial crisis--and are dependent on some $900 billion in emergency financing from the European Central Bank. Conditions in Europe today look a lot like those at the start of America's subprime troubles in 2007, warned a recent Bank for International Settlements report.

Blaming foreign speculators for the continent's troubles may be a popular sport in Paris and Berlin, but most of those problems are entirely homegrown. Europe's dirty secret is that its banking sector is sicker than Wall Street. European banks' losses from the last financial crisis will hit $1.3 trillion by the end of this year, according to the International Monetary Fund's latest forecast--35 percent more than the U.S. total. And while Europe's banks were just as aggressive as America's in gambling on toxic debt, most European governments have done less than America to clean up the mess. Now, European lenders are increasingly nervous about the money they've plowed into overindebted countries like Greece. Together, Europe's banks have funneled $2.5 trillion into the five shakiest euro-zone economies: Greece, Ireland, Belgium, Portugal, and Spain.

If Europe sinks, the contagion could easily spread around the world--by raising worries over public debt, by infecting American banks that are highly interconnected with Europe's, and by killing demand for American goods as Europeans' buying power is shrunk by a falling euro. Coming on top of last month's weaker-than-expected housing and consumer-spending numbers in the U.S., that would present a serious challenge to Barack Obama's recovery strategy, which is based on a doubling of U.S. exports by 2015.

Yet Europe's problems were completely predictable. After Ireland and Iceland both saw their financial sectors collapse in 2008, it was clear that even in Europe, countries could go bust. Yet the continent's banks pumped ever more money into shaky states. French banks were the most reckless, according to BIS numbers, increasing their lending to Greece by 23 percent, to Spain by 11 percent, and to Portugal by 26 percent since the start of the financial crisis. Meanwhile, the ECB rated Greek and other troubled bonds as "risk free" and provided banks with cheap cash to buy them, encouraging subprime countries to borrow heavily at artificially low interest rates.

After the 2008 financial crisis, U.S. and British regulators ran public "stress tests" to separate good banks from bad ones, and then forced unviable ones to restructure and recapitalize. Since then, confidence in the functioning of banks has largely returned. In much of continental Europe, however, bank balance sheets remain shrouded in secrecy. European countries have protected virtually all their banks, allowing them to keep bad debt hidden in their books in the hope that they might one day grow out of it. These "zombie" banks, stuffed full of bad debt, continue to operate and pay out dividends and bonuses. …